Zuora – bet on subscription economy?

Zuora was founded by Tien Tzuo (ex-chief strategy officer at Salesforce) in 2007. Tien coined the term subscription economy to define the shift taking place from product ownership to service consumption (Uber and Netflix are very relatable examples of companies that helped enhance the movement form car and dvd ownership to “as a service”). He started Zuora to help companies leverage the shift.  

In this blog post, we understand Zuora’ business, analyze its financials and value the firm. If the bet on the subscription economy plays out, we believe that the firm could be worth 30% more than what the market is pricing it at.

Business

Zuora provides billing capability to companies starting subscription business or companies pivoting to subscription businesses. This has been there core capability. In the year 2020, Zuora added revenue recognition (RevPro) and platform capabilities (Central Platform) to its arsenal to focus on enterprise customers, which is a larger addressable market.

RevPro: Revenue recognition capability helps reduce the time it takes to close the books and thus decreases the manual effort (required to do revenue recognition) and optimizes the working capital.

Central Platform: Suite of developer tools that was launched early in 2020. It helps automate and orchestrate every touchpoint from the customer from service activation (order), payments, usage, renewals, upgrades, suspensions to internal operations like shipping and recognizing revenue (cash). In short, platform allows companies to extend and integrate Zuora into their business to help those companies orchestrate their subscription order-to-cash process. Platform features are now being used by two-thirds of the customer base (as of 2021-Q3, they had 653 customers with annual contract value of $100,000). Tien Tzuo describes central platform as a key competitive differentiator, particularly within the large enterprise deals i.e. not limited to high growth SaaS companies from Hi-tech and media but larger customers from industrial manufacturers as well e.g., Caterpillar, Briggs & Stratton and others.

Zuora also provides analytics and Configure Price Quote (CPQ) capabilities. Since every customer value different features and have different levels of willingness to pay, CPQ allows sales people the pricing flexibility to offer their prospective customers without burdening the finance team

In summary, Zuora’s cloud-based software functions as a subscription management hub that automates and orchestrates the subscription order-to-cash process, including billing and revenue recognition.

Financials

Since its IPO in April 2018, the company has grown from a revenue of $171M (in FY18) to $276M in FY20 with subscription revenue portion increasing from 71% to 75% (the rest being professional services). By the 9 months (Oct’20) in FY21, they have reported revenue of $226M with subscription revenue portion rising to 78%. They are expected to deliver a revenue of $302M by the end of FY21 (Jan’21) with subscription portion 79%.  Moreover, customers with ACV equal to or greater than $100,000 was 653 by FY21-Q3 (Oct’20). They had 624 customers with ACV equal to or greater than $100,000 by FY20 (Jan’20). This group of customers represent 90% of their subscription revenue.

The company expects a CAGR of 25-30% over the next few years, but the market is not very optimistic (wouldn’t blame the market!). Their annual growth rate has declined from 51% in FY18 to 17% in FY20 (and further to 9% in FY21E). Although, they have not been growing at break-neck speed, but with the focus on enterprise customers, the growth is expected to pick up not in terms of # number of customers, but in terms of higher ACV. By end of FY20, they averaged ~$298K subscription revenue per customer.

What is going well for them is their strategy to move professional services to system integration (SI) partners. Professional services constitute the consulting and integration effort spent by Zuora’s human capital. This segment has historically operated at a loss (and so it makes sense to move it to SI partners who can do this cheaper) and they expect it to operate at cost moving forward.

Valuation

Value of a firm is the present value of projected Free Cash Flows (FCF) to the Firm (FCF). FCF is the the portion of net operating profit after tax that is left after meeting the firm’s reinvestment needs. So to value a firm, one needs to project operating profit and reinvestments 5-10 years out (and discount them to present using the firm’s cost of capital)

We now project out revenue, margin and reinvestments to value the firm.

Revenue projections:

a. As per the following excerpt from Zuora’s FY20-Q4 earnings call “we see ourselves as a portfolio bet on the entire subscription economy, a position that gives us the opportunity to deliver 25% to 30% sustained growth over a long period of time. But what we see in these last couple of years is that the subscription economy is no longer just about high-growth SaaS companies like Zoom or Foresight. Subscription business models are being adopted by some of the largest companies across multiple industries all around the world. ” With enterprise focus backed up by new arsenal of products, we build our projections on Tien’s guidance of 25% growth in Subscription Revenue for the next few years. We assume that the growth continues till FY25 and we cap it to 15% by FY30
b. Aligned with the strategy to move services to SI partners, Professional Services Revenue reduces from 20% in FY21 to 10% by FY25 and further to 5% by FY30
As a result of these guiding principles, Zuora makes their first $1B in annual revenue by FY28.

According to a Markets and Markets report, the global subscription and billing management market is estimated to grow at 14% CAGR to reach $7.8 billion by 2025. As per our FY25E projections, Zuora will acquire a market share of 8.3% by 2025. There are other research reports with varying market sizes. MGI Research Forecast Report on Subscription Economy SaaS Tools estimates a $102 billion total addressable market (TAM) from 2016 to 2020, with 20% of Fortune 1000 companies adopting cloud-based enterprise solutions during that time

We could have anchored our story on an x% market share acquisition by FY25 and backed out the revenue projections from there, but we opted out of that approach since a.) Zuora has added products beyond billing and b.) there are high variance in addressable market sizes across different research reports. We have built our projections on shift happening from “product centric” to “as a service” models, which is based on the founder’s story.

Margin projections:

a. Subscription segment gross margin increases from 75% in FY21 (present) to 80% by FY25 and remains at this level from then on.
b. Professional Services operate at cost from FY25 onwards. As per the FY21-Q3 earnings call they are aiming to operate at cost sooner.
c. Non-direct OpEx decline as the firm scales resulting in first operating profit (~3%) in the year 2025 and it gradually increases to 22% (avg op margin of software app firms) by FY30.

Re-investment projections: We use capital efficiency ratio to estimate re-investments back into the firm.

Re-investment = Growth in Sales (in $) / Capital Efficiency;
Invested Capital = Working Capital + PPE + Goodwill + Intangibles + Operating Lease Asset + Capitalized R&D + Other Assets (excluding cash) OR
Invested Capital = Book value of Equity and Debt + Capitalized R&D - Cash

We capitalize R&D since the benefits of R&D extend beyond one year. This adjustment has a positive impact on the margin but it penalizes the capital efficiency.

We calculate a Capital efficiency of 1.19 for FY21 i.e. they make $1.19 of revenue on an invested capital of $1. We assume the same capital efficiency in the future years. We do not assume a reduction with scale since software application firms typically operate with a capital efficiency of close to 1 (after adjusting for R&D and operating leases)

Terminal Growth and ROIC: The firm will have competitive advantage and create value beyond year 10. With this belief, we assume an ROIC greater than the cost of capital beyond year 10.

We also believe that the 10 year T bond rate (or the risk free rate) will eventually rise to 2% from 1.1% now. With this belief coupled with the fact that firm will do well beyond 10 (albeit marginally), we assume a terminal growth rate (3%) higher than the risk free rate. If you think that this is too high or too low, we’d request you to hang on since we do measure share value sensitivity on the risk free rate towards the end of this section.

Since, Terminal Reinvestment rate = Terminal Growth / Terminal ROIC

We estimate the terminal reinvestment rate at 25%

Cost of Capital: We have estimated a cost of capital of 6.49% in the base year. We assume that the cost of capital will gradually increase to 7.36% with the rise in T bond rate (risk free rate) to 2%. We do measure share value sensitivity on the cost of capital sensitivity towards the end of this section.

Putting it all together: Using the above assumptions and guiding principles, we estimate the enterprise value at ~$2.31B. We value the 7.9 M outstanding employee stock options at $83M and after netting off debt, options and adding back cash, we get a fair market value of the business at ~$2.33B, which is $19.7 per share. As of 1/22/20, Zuora traded at $15 a share.

We do a sensitivity analysis by varying terminal growth and cost of capital. The lowest fair share value that we get is $16.9, which is again higher than the trading price.

Return

As of this writing, Zuora is trading at a forward enterprise value to revenue (FY22) multiple of 4.6x (=$1674M / $364M). For context, SaaS companies are trading at a forward avg multiple of 20.5x and median multiple of 18.5x.

At the same 4.6x multiple 5 years out, Zuora will yield a compounded return of 15.5%.

Market Cap in FY26 = Current market cap ~$1.78B * (1+ Return 15.5%)^5 = ~$3.66B . Adding debt and netting off cash gives an EV of $3.55B (in FY26). Dividing this by FY26 revenue of $0.77B (refer projections exhibit): $3.55B / $0.77B = 4.6x

We have also computed the return at higher (and lower) multiples if you believe Zuora plays out this story and market begins rewarding (continues ignoring) the firm by pushing up (dragging down) the multiple.

Thanks for reading.

Gautam

Disclaimer – Currently, I do not own any stock of this company. This analysis should not be misconstrued as a buy / sell recommendation. Readers are advised to do their own analysis. Moreover, any opinion expressed in this blog post is solely my own and does not represent views of my employer